Investment markets and key developments over the past week

It’s been another volatile week in financial markets as investors continue to fret about the global growth outlook, but strong signs from the European Central Bank (ECB) of further monetary easing helped shares and other risk assets rebound after falling earlier in the week. As a result despite earlier sharp falls US shares rose 1.4% over the week, Eurozone shares gained 2.3% and Australian shares rose 0.5%. Chinese shares also rose 0.9%, but despite a late surge Japanese shares still ended down 1.1%. After plunging to a new low of $US26.6/barrel the oil price managed a 9% gain over the week and metal prices also rose. The ECB inspired bounce in risk assets later in the week also helped push the A$ back up to around US$0.70, and saw bond yields mostly rise over the week.

From their highs last year to their lows in the past week many global share markets have already fallen into bear market territory (defined as a 20% decline from the high – which this time around was last year). Asian shares (down 28% from last year’s high) and emerging market shares (down 27%) entered bear market territory last year. Japanese shares have had a fall of 23% and Eurozone shares have lost 22%. Australian shares have come close with a fall of 19% from the high in April last year but US shares have only had a decline of 13% from last year’s high.

With global growth worries likely to linger and US shares having only had a 13% fall despite having more valuation concerns than other markets it’s too early to say that we have seen the low. So the Australian share market could yet be tipped into bear market territory.

However, there were some more positive signs over the past week. First, Chinese economic data over the last week was much better than feared and the Chinese Renminbi has remained relatively stable.

Second, share markets have become very oversold, with some technical indicators (Relative Strength Index, for example) at levels often associated with at least short term lows and a bounce, which we may be starting to see.

Third, signs of extreme pessimism and investor capitulation are continuing to build, with our investor sentiment index for US shares nearing levels associated with bounces.

Finally, central banks are turning dovish. This started with the US Federal Reserve’s (Fed) Bullard last week, with the ECB now also signalling more easing at its March 10 meeting and the Bank of Japan (BoJ) is reported to be considering further easing too. More easing from the ECB is likely to take the form of a €10-15 billion/month increase to its quantitative easing program and another deposit rate cut. In the week ahead the Fed is likely to signal a pause in raising interest rates to allow it to reassess the outlook and the Bank of Japan is expected to at least signal that it has become more dovish.

Our high level view remains that if there is to be a US/global recession then share markets have much further to fall (eg another 20% plus), but if recession is avoided and global growth continues to muddle along around 3% pa then further downside in markets is likely to be limited and they are likely to stage a decent recovery by year end. We see a recession as being unlikely because we have not seen the normal excesses – massive debt growth, over investment or inflation – along with aggressive monetary tightening that invariably precede them.

While on global growth, the IMF downgraded its global growth forecasts for 2016 to 3.4% (from 3.6%) and for 2017 to 3.6% (from 3.8%). This was largely due to growth downgrades in the emerging world and the US. It’s worth noting that though that IMF growth downgrades have been the norm for the last five years now with the IMF typically starting off with a growth forecast of close to 4% for each year and then having to downgrade it to usually end up around 3%. On one level its negative as it highlights the fragile and constrained nature of global growth since the GFC. But it should also mean that the days of rising inflation and much higher interest rates leading to a sharp economic downturn is a still long way off.

Major global economic events and implications

In the US, home builder conditions and housing starts were a bit weaker than expected but remain solid and should be supported by rising household formation. Existing home sales rebounded strongly and the Markit manufacturing conditions PMI rose 1.5 points to 52.7 in January, providing a possible sign that the inventory correction in manufacturing may be over. Meanwhile headline and core inflation was weaker than expected in December. So far only 73 S&P 500 companies have reported December quarter earnings with 78% beating on earnings but only 48% beating on sales.

Eurozone business conditions PMIs slipped in January but remain at solid levels pointing to continued okay growth.

Chinese December quarter GDP growth at 6.8% year on year and December activity data were both fractionally weaker than expected, but not dramatically so. It tells us that growth is still soft but it’s not collapsing. Policy stimulus measures are helping, but more is needed to help the economy as it transitions from a reliance on manufacturing and investment to services and consumption. This transition is evident in industrial production growth of 5.9% over the year to December (which is down from 10% plus up until about four years ago) in contrast to retail sales growth of 11.1% year on year. Chinese shares were able to rally on this news, which tells us that a much worse outcome had been “feared”. This year, I expect Chinese growth to edge down to a 6.5% pace, with policy stimulus measures helping avoid a sharper slowing. Continued gains in Chinese property prices for December highlight that the risks from a property collapse are continuing to recede.

Australian economic events and implications

Australian economic data releases were generally on the soft side. Consumer confidence fell in January, presumably in response to news of market turmoil, leaving it a bit below average and new home sales fell in again in November. While housing starts rose to a record high in the September quarter, the softening trend in building approvals and new home sales suggest they are likely to have peaked. Meanwhile the TD Securities Inflation Gauge for December points to continued low inflation.

What to watch over the next week

In the US, the big one to watch will be the Fed meeting on Wednesday. The Fed won’t be making any changes to monetary policy, but is likely to be dovish in acknowledging the latest downside risks to inflation and support the view that a March hike is now unlikely. The US money market puts the probability of a March hike at just 22%, and with the way things are going, it’s increasingly likely that the Fed will struggle to put through even one 0.25% rate hike this year.

After the Fed, the focus in the US will shift to the December quarter employment cost index, which is likely show that wages growth remains benign at 2.1% year on year and December quarter GDP growth, which is likely to show growth slowing to just 0.8% annualised, due to a large detraction from inventories (both due Friday). In other data, expect to see further gains in home prices and little change in consumer confidence (both Tuesday), modest gains in December new and pending home sales and soft December durable goods orders (Thursday).

Eurozone inflation for January (Friday) is likely to remain very low helped by the latest plunge in oil prices.

Expect Japanese data for December on Friday to show continued labour market strength but softness in household spending and industrial production. Core inflation is likely to slip to around 0.8% year on year from 0.9% in November. The Bank of Japan (Friday) is likely to be at least more dovish.

In Australia, expect a 6% drop in petrol prices to result in December quarter inflation of 0.3% quarter on quarter or 1.6% year on year (Wednesday). Despite the lower A$, ongoing discounting is expected to keep underlying inflation low at 0.5% quarter on quarter or 2.1% year on year. Inflation is not likely to be low enough to trigger another RBA rate cut in February by it will be no barrier either. The December NAB business survey will also be released Monday, December quarter export and import prices (Thursday) are likely to show a further fall in the terms of trade and credit growth (Friday) will likely show a further slowing in lending to property investors.

Outlook for markets

It’s still too early to say that shares have bottomed, but given increasing pessimism, indications that shares are oversold and more dovish central banks there is a good chance we will see at least a short term bounce. In fact, as seen over the last few days, this may be already getting underway. Beyond the near term uncertainties we still see shares trending higher, helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the A$ is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the A$ undertakes its usual undershoot of fair value. Expect a fall to around US$0.60 by year end.